CMA Study Group

Part 2: Relevant Cost between Make V/S Buy

  • 1.  Part 2: Relevant Cost between Make V/S Buy

    Posted 11 days ago
    Hi Folks,

    I have few doubts in below question, Much Appreciated if someone can help.

    ABC manufactures ice-makers for installation in refrigerators. The costs per unit, for 20,000 units of ice-makers, are as follows.
    Direct materials $ 7
    Direct labor 12
    Variable overhead 5
    Fixed overhead 10
    Total costs $34
    XYZ Inc. has offered to sell 20,000 ice-makers to ABC Company for $28 per unit. If ABC accept XYZ' offer, the facilities used to manufacture ice-makers could be used to produce water filtration units. Revenues from the sale of water filtration units are estimated at $80,000, with variable costs amounting to 60% of sales. In addition, $6 per unit of the fixed overhead associated with the manufacture of ice-makers could be eliminated.
    For ABC Company to determine the most appropriate action to take in this situation, the total relevant costs of make vs. buy, respectively, are
    a. $600,000 vs. $560,000.
    b. $648,000 vs. $528,000.
    c. $600,000 vs. $528,000.
    d. $680,000 vs. $440,000.

    Correct answer c. The relevant cost to make the ice-makers is $600,000; to buy the units, the relevant cost is $528,000 as shown below.
    Make: 20,000 x ($34 - $4*) = $600,000
    Buy: ($28 x 20,000) – ($80,000 x .4) = $528,000
    *The $4 of remaining fixed overhead applies to both alternatives and there irrelevant to the decision.

    MY ANSWER - 632000 and 560000.

    Cost of Making = Variable cost + Avoidable fixed cost + Opportunity cost.
    632000= 480000(7+12+5* 20000)+ 120000(6* 20000)+ 32000(80000*40%)

    Cost of Buying= purchase price* quantities
    560000= 20000*28.

    MY QUESTION: Why the Opportunity cost 32000 is not considered in cost of making as that will be the foregone revenue.
                               Why the Contribution margin from water filtration  is deducted from cost of buying the ice maker.

    Thanks in advance.





    ------------------------------
    Prajnya Shetty
    GL Executive in XPO Logistics
    India.
    ------------------------------


  • 2.  RE: Part 2: Relevant Cost between Make V/S Buy

    Posted 9 days ago

    Hi every one,

    The problem asks for the relevant costs doesn't ask for  total costs.

    The relevant manufacturing costs is only total avoidable cost internally. So, total costs is (30+4) /unit but if ABC stops making products it will avoid only (30) and the other 4 will continue.

    The relevant of buying from outside  is only net of total paid costs. So, total cost is 28 minus 1.6 /unit = 26.40 $/unit.

    So 4$ is fixed and will not change whatever the decision Make/Buy.

    Finally relevant costs for making = 30 not 34

    Finally relevant costs for buying = (28-1.6) not 30.4

    Of course total cost is 34 for making and 30.4 for buying respectively

    Please note 1.6 = (80,000*0.4)/20,000

     

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